Counterparty credit risk has been one of the fastest growing exposures on derivatives dealers’ books in the last several years. Natasha de Terán explores how they have been managing this risk amid the mounting market turmoil.

Growth in the over-the-counter (OTC) derivatives business and leveraged investments has led to a considerable increase in counterparty credit risk. In the wake of the last major market downturn in 1998, when counterparty credit risk last hit the headlines, a series of supervisory and market-led initiatives were put into place, examining both what had gone wrong and detailing what could and should be improved. Dealers then worked on reinforcing their risk processes and the legal documentation that underpins their management of these risks, developing new tools and systems to measure, shed, redistribute and mitigate these risks.

The promise

The thinking had long held that these efforts have radically improved dealers’ ability to manage their credit risk exposures sensibly and sensitively, but the efforts were rapidly followed by a period of abundant liquidity and a highly competitive marketplace, in which dealers fought fiercely to service the leveraged investment sector. Now that fast-plummeting asset prices are coinciding with deteriorating counterparty credit assessments, the new processes are being put to the test.

So far, the evidence and sentiment are relatively good. Robert Pickel, CEO and executive director of the International Swaps and Derivatives Association (ISDA), believes that dealer firms are in much better shape, not least because of the growing use of both collateralisation and credit derivatives. “It’s easy to underestimate the mitigating role that collateral is playing in this period of volatility. In developed markets, the majority of positions are collateralised. It is already standard routine to make daily collateral valuations and margin calls; market participants value their trading positions and their collateral holdings every day.

“Furthermore, under the ISDA’s guidance, there has been a great deal of focus on collateral asset quality. Collateral held is likely to be cash or US government securities, and there are a range of steps that participants can and should take to make sure their collateral is liquid,” he says.

Mr Pickel also says that credit derivatives have served to disaggregate large pockets of risk from lenders that might otherwise suffer from having too much concentration at times such as those in the market recently, and they help to reduce contagion in times of crisis.

Chris Arnold, an associate at Allen & Overy’s international capital markets practice in New York, also believes that the situation should be in much better shape during this downturn. “Derivatives documentation is more robust, particularly on the credit derivatives side; the Fed-14 initiative on confirmations has gone a long way to reducing the time-lag between trade execution and documentation; banks have continued to closely monitor counterparty credit issues and have increased the proportion of trades being collateralised over the past few years,” he says.

The practice

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According to Jerome Ranawake, a partner at Freshfields Bruckhaus Deringer in New York, the main way in which dealers manage their risk during periods of market turmoil is through close monitoring of their counterparties’ net asset value (NAV) levels.

 

Dealers will typically embed into their ISDA master agreements termination triggers that are linked to falls in their hedge fund counterparties’ NAV levels, he says. The triggers will be set at, say, 15%, 25% or 35% levels, and the funds’ NAVs will be calculated and reported on a monthly, quarterly or annual basis. The triggers allow broker-dealers to effectively terminate funds if and when their NAVs fall below the pre-agreed trigger levels.

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However, Robert McWilliam, head of counterparty exposure management at ABN AMRO, points out that NAV triggers (and the ratings-linked thresholds that are sometimes used in their stead) are imperfect. “Rating moves are lagging indicators. You will often have to wait for a three-month drop in an NAV to be able to call for additional collateral from affected counterparts,” he says.

 

Another issue with termination triggers that Mr Ranawake highlights is that they only give broker-dealers a ‘nuclear option’. “They give dealers close-out rights, which is rather like holding a gun to a hedge fund’s head,” he says.

One way in which dealers have addressed these issues, and which Mr Ranawake says has been gaining currency (at least in Freshfields’ New York practice) is by moving toward so-called super-collateralisation. The way this works is by using two sets of NAV triggers, one of which is set forth in the schedule to the ISDA master agreement and which continues to give rights to termination events, and another, more finely tuned trigger, which is set forth in the credit support annex (CSA) to the master agreement and which instead requires that counterparties post additional collateral for so long as the relevant trigger is tripped.

“The CSA hair-triggers are lower and will typically be tripped first, giving rise to calls for additional collateral, rather than the more drastic measure of closing out the fund’s transactions,” says Mr Ranawake.

The super-collateralisation requirement, if invoked, will in any event create a liquidity strain for the fund – as has been exhibited by some funds’ recent asset sales to meet collateral calls. It could also lead to disputes over the valuations put on less liquidly traded assets and OTC exposures – although the lawyers, bankers and the ISDA downplay the likelihood of these leading to litigation.

Mr Pickel says he understands there may have been “a handful” of disputes involving collateralised positions, but that they have been managed in orderly work-outs. “In periods of high volatility, the difficulty of observing the price of any single instrument may lead to temporary differences, but there does not appear to have been a significant increase in margin calls being disputed and indeed it is widely agreed that calls are being met as a matter of course,” he says.

It is almost inevitable that some margin calls will lead to disputes, says Mr Arnold, not because of flaws in the margin processes or in the supporting documentation, but because there will be differing views about asset pricing, particularly in the less liquid markets. “But because ISDA contracts are quite clear about valuing margin calls, any counterparties correctly using and following these documents and processes should be able to rely on the provisions in any legal action that may be brought against them,” he says.

Twists and tweaks

A more immediate concern for both risk management groups and regulators might be the extent to which dealers have agreed to unduly lax conditions or included twists and tweaks to these agreements. NAV trigger conditions, for instance, tend to be heavily negotiated and can include a number of variations: depending on a fund’s negotiating power the trigger points will be set higher or lower, and the NAVs will be examined on a more or less frequent basis.

Another key point is whether the trigger levels are inclusive of redemptions by investors or not. In terms of agreement twists, funds have recently been seeking to put so-called margin lock-up agreements in place. These ‘lock in’ prime brokers’ margin and collateral requirements for a specified period of time and prevent them from altering pre-agreed margin requirements, margin lending financing rates, or demanding repayment of margin or securities loans or any other debit balances.

Although they sound heavily weighted in the funds’ favour, Mr Ranawake stresses that the arrangements are themselves subject to termination events, which typically include NAV triggers that will generally match the NAV triggers in a fund’s ISDA master. “Once the lock-up is terminated, the dealers are protected insofar as they can require as much additional margin to be posted as they like,” he says.

Equally, Mr Ranawake stresses that even in cases in which funds have sought to negotiate more lenient NAV triggers, prime brokers will usually have demanded “most favoured nation status” – agreeing to higher trigger thresholds, but in return insisting that the funds effectively guarantee that they do not have any lower trigger thresholds in place with other counterparts.

Brokers’ backbones

Still, views are mixed about the extent to which dealers might have been overly lax of late. Mr Arnold concedes that banks and prime brokerages have been keen to capture money flowing into hedge funds, but says he is not unduly concerned. “I am not sure that will necessarily have encouraged them to take a softer line on things like NAV triggers, haircuts, margins and the like. Certainly, we have not witnessed the introduction of anything analogous to the cov-lite loan type arrangements into OTC documentation,” he says.

In contrast, Mr McWilliam says he imagines that some banks and prime brokerages “will be wishing they had negotiated tougher covenants and tighter collateral agreements”. Mr Ranawake’s agrees: “A lot of prime brokers are now re-examining the margin lock-ups they have in place, looking to renegotiate their terms, while many margin lock-up negotiations currently being conducted are now being put on hold or revisited in their entirety.”

New tools

Although there is a great deal of reliance on collateralisation and the CSAs that govern its usage, in some jurisdictions CSAs are not enforceable and in other instances counterparties will refuse to sign them. “This can be for very legitimate reasons: either because they don’t view the position as being as risky, because they are happy to deal with a AA-rated bank, because they believe it will jeopardise their rating, or because they find them operationally burdensome to manage,” says Mr McWilliam.

Some counterparties, such as corporates, rarely use CSAs, but Mr McWilliam says that banks have been able to get around this by offsetting some of the credit risk by buying credit default swap (CDS) protection on their names. Alternatively, and when corporate names are not liquidly traded in the CDS market, banks will use collateralised debt obligation (CDO) technology to protect themselves, Mr McWilliam says. “For instance last year we sold €7bn worth of our illiquid corporate credit exposure into the market through credit linked notes under our Amstel programme,” he says.

One of the newer tools at dealers’ disposal to get around counterpart’s refusals to use CSAs – and which many now expect to come into its own – is the so-called contingent credit default swap (CCDS). Used to manage counterparty credit risk, CCDSs are essentially a new form of CDS that allows market participants to directly hedge their OTC credit exposure. In a normal CDS, the notional exposure (or risk) that is being hedged is the credit risk in a bond or loan and is defined at the outset of the transaction. In a CCDS trade, in contrast, the exposure that is being hedged is the credit risk premium arising from another OTC trade. As such, the risk premium being hedged changes during the life of the transaction according to market movements in the underlying contract.

Though the product is still new, Mr Arnold says that banks that are already using CCDSs have been “quite pleased” with the take up of the product, while those on the sidelines may consider using them soon.

In the meantime, and even if things look solid as the current turmoil continues to unfold, it is also likely that the existing risk management practices will be re-examined and the documentation upgraded. “ISDA documentation is constantly evolving to reflect developments in the market, and there was already talk of updating the collateralisation annexes. So I would not be surprised if this issue were revisited in the wake of the current market events,” says Mr Arnold.

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